Free exchange

Strength in numbers

How much capital did banks opt to hold when they had the choice?

IN 2008 the Royal Bank of Scotland (RBS) was the biggest bank in the world, with assets of £2.4 trillion ($3.5 trillion). It was sunk by a loss of £8 billion, or 0.3% of its assets. RBS and its regulators had let the simplest measure of balance-sheet strength, how much equity it had compared with its total assets, fall below 1%. Other lenders were in similar positions. In response regulators want banks to hold more capital. Banks in turn warn that new rules will choke credit. What light can history shed on the debate?

Equity comes with benefits and costs. Start with the benefits. Along with wholesale debt and deposits, equity is one of banks’ three main sources of funds. These funds (a bank’s liabilities) are channelled into assets of various types. But assets are risky, and in a downturn their value can fall. A bank’s liabilities must then also fall to ensure that what it is owed and what it owes add up. Equity is the balancing item, taking the hit so that debt and deposits are shielded from losses. As a bank’s equity cushion rises, the hit that it can absorb gets bigger, too.

But shock-absorbing equity comes with costs too. Take Danish banks, which had average capital ratios of 75% in the mid-1800s. A bank like this, funded mainly by equity, can make loans to borrowers but has limited capacity to accept deposits. Turning short-term deposits into long-term loans is one of the main reasons banks exist, enabling customers to have the comfort of deposits that can be withdrawn at any time together with the certainty of mortgages that might last for 25 years.

Even at lower ratios capital has its costs. Although more equity implies a safer bank and can lower debt costs, it still tends to mean a higher overall cost of capital. The tax advantages of debt, specifically the tax deductibility of interest payments, can also cause firms to favour debt over equity financing.

Capital-ratio decisions must balance these costs and benefits. Until regulated capital ratios were introduced with the first set of Basel accords in 1988, banks picked their own levels of equity. Over time, they opted for less and less. In a 2005 paper Harald Benink of Tilburg University and George Benston of Emory University tracked European banks’ equity-to-assets ratios. In 1900 the average across six European countries was 24%. By 1992 it had fallen to just over 5%. American capital ratios fell too, from 55% in 1840 to about 7% in 1992. Canada saw similar trends.

A benign reason why banks thinned their capital cushions was that a rush of bank mergers meant banks became more diversified. In 1900 Britain had 188 banks and Canada had 35. Within 25 years over half the banks had disappeared in both countries. The enlarged banks spanned different regions and were no longer exposed to one area or industry. Forrest Capie of Cass Business School and Mark Billings of Exeter University have mapped this effect in Britain: because Midland Bank was large and diversified, for example, it held less capital than Martins, a bank with heavy exposure to Liverpool’s households and firms.

Another reason banks’ capital buffers dropped was less positive. America’s banking landscape is still crowded with lenders, but it suffered a wave of bank failures following the 1929 Wall Street crash. In 1933 the Federal Deposit Insurance Corporation (FDIC) was set up to ensure that depositors were paid back in the event of a bank failure. The existence of the FDIC meant that depositors’ safety was less closely tied to their bank’s capital position. As the public cushion fattened, the private ones slimmed.

British banks between 1920 and 1970 provide an insight into what happens when neither consolidation nor safety nets are at work. The merger era was over (the big five banks already had 80% of deposits by 1920). Deposit insurance did not exist, so the banks relied on their own capital cushions to protect them from unexpected hits. The tax treatment of debt was relatively stable. The banks’ capital ratios were nonetheless pushed down by two forces. The second world war forced the British government to borrow heavily, issuing debt that the banks bought, inflating their assets. In an attempt to let the post-war government raise finance more easily, banks and many other private firms were prohibited from issuing fresh equity. With assets up and equity capped, banks’ published capital ratios fell to around 2.5%.

Man bites dog

The banks’ reaction was an unfamiliar one by modern standards. They lobbied government to be allowed to issue new equity. They retained earnings, building up secret reserves: Mr Capie and Mr Billings show that actual capital was often twice the level of published capital. Adjusting for this, their true capital ratios were around 5% on average. And when the equity-issuance restrictions were lifted in 1959 the big five tapped the market within a year. In the absence of state support British banks clearly thought that a 5% equity-to-assets ratio was too low.

For comparison, the new Basel 3 capital standards require a “risk-weighted” common-equity ratio of 7%. This translates into an equity-to-assets ratio of perhaps 3.5%, lower than the banks themselves thought prudent in the years before Basel. History also weakens the argument that the new rules will choke credit growth. Although it is true that the years of strongest credit growth before Basel coincide with the years of lowest capital (see chart below), banks still had more equity than Basel 3 requires.

The high-capital years had decent credit growth, too. Between 1880 and 1914, the average capital ratio in Britain and America was 17.3%. Yet in that period bank assets grew from around 30% of GDP to 80% in America, according to a new paper by Moritz Schularick of the Free University of Berlin and Alan Taylor of the University of Virginia. In Britain they went from 31% to 51%. The banks are right that equity has a cost, but the new capital framework is anything but excessive.